A Q&A on Passive Investing: How Pactive Are You?

The passive versus active debate is heating up again, with many going so far as to claim 2014 shows passive investing-the notion markets are unbeatable, so give up, mirror a selected index and never make moves-has won the day. Yet, true passive investing is rare. More often than not, folks are making active investment decisions even though they claim to be passive, rendering them pactive.^[i] There is no real evidence pactive investing is superior to active. Here is a Q&A to illustrate this point.

Q: How did you determine your asset allocation?

A: Before you even elect to go passive or active, it's crucial to determine which mix of stocks, bonds, cash and other securities to employ. Studies have shown this decision alone accounts for between 70% and 90% of your longer-term investment results. (That dwarfs any active or passive decision's impact.) So how did you get your allocation? Did you subtract your age from 100 to get the percentage you invested in stocks? Use another method? Did you take your time horizon and other long-term financial factors into account? Did you answer a risk tolerance questionnaire? No matter which method you chose, this is a choice. And often, investors choose allocations that aren't in keeping with their goals, focusing too much on volatility, fear or greed. Right out of the gate there is significant room for error-and an inherently active choice. But even if we overlook this active choice, passive investing's problems don't end.

Q: Once you determined your asset allocation, how did you pick indexes for each asset class?

A: After determining a mix of stocks, bonds, cash and other securities, a passive investor must select an index representing each asset class. One for stocks, one for bonds, etc. But here again, there is no default equity index option for passive investors, which product offerings show: One major provider offers no fewer than 18 equity and 12 bond index funds.^[ii] Pick the S&P 500, and you are shunning about 50% of investible assets. Is that passive or active? The same can be said for bonds if your allocation includes fixed income. What types of bonds will your portfolio index? US Treasurys? Municipal bonds? What about corporate bonds? High yield? Foreign? Agency? Each decision made in this arena is an active decision on the investor's part. Some try to solve for these issues by suggesting you use multiple funds, raising another set of issues.

Q: Is it still considered passive investing if I use more than one index per asset class?

A: No. If you don't mirror an index, you can't pretend you are passively indexing. After all, who decides on the percentages you put in, for example, US and foreign indexes? Some proponents of "passive" suggest stuffing rather arbitrary percentages into each. But hold on-those weights are inherently an active choice. The world isn't, for example, 75% US and 25% EAFE.^[iii] In the example linked, this active decision hinges on the bizarre notion foreign is risky and US safe-which goes against all the foundational philosophy behind passive, which is that market efficiency prevents permanent superiority. Even if you choose indexes mirroring the world equity market structure, you have other questions to address.^[iv]

Q: Am I still passively investing if I regularly rebalance, as some passive proponents suggest?

A: Owning multiple funds introduces the added issue of rebalancing or, said differently, trading. How do you keep your portfolio in line with the initial allocation or mix you designed? Performance differences between various indexes or asset classes mean your mix will be thrown. You will eventually have to prune from higher returning areas and buy lower. How often will you do this? What if stocks surge over a short period? What if one index you chose surges massively in a short time frame? Or, alternatively, if stocks are deep into a huge bear market or correction, should you respond to that by buying more? Not if you're passive, because that's market timing, pactive friend! And there is no evidence whatsoever investors are any better at timing indexes or asset classes than they are individual securities.

Q: Can you really be passive?

A: Well, frankly, we're not sure. If we give you a pass on asset allocation, then we guess it's possible. But it's extremely difficult. Passive investing would basically require buying one index fund per asset class and doing nothing, come whatever may. That "come whatever may" is way more difficult than you might think today, after nearly three years of correction-free, lower-than-average-volatility, big bull market. But emotions can, and often do, get in the way. When volatility strikes, fear often causes many passive investors to sell and go to cash. Conversely, greed during bull market peaks can cause investors to chase hot indexes or sell bonds (should they own bonds). Studies have long shown how hard it is for investors to hold on to funds for even moderately long periods. According to market research firm DALBAR, between 1993 and 2013, equity fund investors held funds for an average of 3.3 years. That's about half this bull market to date, for some perspective-entirely insufficient to prove passive is broadly happening. ETF fund flow data shows trading spikes when volatility does. Heck, even some self-proclaimed passive investors decide it's just too "fun" to be active (or maybe that fun is greed?)-and invest portions of their portfolios in individual stocks. Of course, active investors struggle with emotion too. But active investors' strategy involves trading, while a passive investor trading is invalidating their entire investment thesis.

At the end of the day, what most folks presume is passive is most often an actively selected asset allocation and sector picking. Which leads us to our final question:

Q: Is there any evidence suggesting passive investors who self-determine their asset allocation, sector select, randomly rebalance and get no counseling through tough times reach their goals faster than those paying for active management?

A: Nope.

And in the end, that's what really matters most.

Stock Market Outlook

Like what you read? Interested in market analysis for your portfolio? Why not download our in-depth analysis of current investing conditions and our forecast for the period ahead. Our latest report looks at key stock market drivers including market, political, and economic factors. Click Here for More!

[i] That's a comberation of passive and active. Other comberations of the two weren't appropriate.

[ii] And some things called "balanced" funds, which they claim are index funds, but are actually target-date funds. Buyer beware.

[iii] Canada is very offended that you would even think this.

[iv] Like Canada!